8 suppose the federal reserves short run response to

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8. Suppose the Federal Reserve’s short-run response to any change in the economy is to change the money supply to maintain the existing real interest rate. What would happen to money supply if there were a reduction in government purchases? Given the Fed’s policy, what would happen in the very short run (before general equilibrium is restored) to output and the real interest rate? What must happen to the LM curve and the price level to restore general equilibrium? Answers: The decrease in G shifts the IS curve down and to the left. The Fed’s policy decreases the money supply and shifts the LM curve up and to the left, so the real interest rate doesn’t change. But output declines in the very short run. To restore general equilibrium, the price level must decline to shift the LM curve down and to the right. If the Fed wanted to keep the price level from changing so much, its correct policy would have been to increase the money supply, not decrease it. Level of difficulty: 3 Section: 9.5
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Chapter 9 The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis 147 9. Suppose you were a forecaster of the real wage rate, employment, output, the real interest rate, consumption, investment, and the price level. A shock hits the economy, which you think is a temporary adverse supply shock. (a) What are your forecasts for each of the variables listed above (rise, fall, and no change)? (b) What if the shock was really due to people’s reduced expectations about their future income. Which variables did you forecast correctly, and which did you forecast incorrectly? Answers: (a) The real wage rate, employment, output, consumption, and investment decline, while the real interest rate and the price level rise. (b) The IS curve shifts down and to the left, instead of the FE line shifting left, so you are wrong about every variable except consumption. The real wage, employment, and output won’t change, the real interest rate and the price level will decline, and investment will rise. Level of difficulty: 3 Section: 9.5 10. Describe the effects, in both the short run and the long run, of an increase in the money supply. Explain what happens to real output and the price level. Answer: In the short run, an increase in the money supply increases output and has no effect on the price level. In the long run, an increase in the money supply has no effect on output and increases the price level. Level of difficulty: 1 Section: 9.6
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